2012 Quarterly Summaries

Review of Securities Markets, Third Quarter, 2012

Stocks surged in the third quarter due in large part to the accommodating monetary policies of central banks around the world. European Central Bank President Mario Draghi set the tone in late July, stating that the ECB “is ready to do whatever it takes to preserve the euro, and believe me, it will be enough“. Investors took this as their cue to begin piling into risk assets, pushing global equity prices higher. Just as the initial euphoria started to wear off, the ECB announced the details of its latest bond buying program entitled Outright Monetary Transactions (OMT). The OMT allows the ECB to purchase unlimited amounts of sovereign debt in the secondary markets in order to restore investor confidence in the euro.

Not to be outdone by his European counterpart, Federal Reserve Chairman Ben Bernanke unveiled the Fed’s latest bond buying program (QE3) that will focus on purchasing mortgage-backed securities until the U.S. jobs market significantly improves. In response, U.S. stocks rose. Contrary to what we might expect in a risk-driven environment, large company stocks continued to outperform small companies so far this year. The S&P 500 gained 6.4% in the third quarter, posting year-to-date returns of over 16%.

After a weak second quarter, foreign stocks rallied in the third quarter, with the MSCI EAFE index of developed-market stocks returning 6.9%. While the European debt crisis is far from being resolved, the ECB’s actions have helped to reduce the “tail risk” of a break-up of the Eurozone.

The yield on 10-year US Treasuries reached an all-time low of 1.38% in late July and ended the quarter just above 1.6%. Bonds of lower credit quality, often referred to as “junk” bonds, outperformed for the quarter as investors stretched for yield. Municipal bonds also benefited with the Barclays Capital Municipal Bond index up over 6% for the year.

Of Politics and Policy

Four years have passed since the worst of the financial crisis unfolded in September 2008. Since then, central bankers from around the world have played a pivotal role in managing the post-crisis and recovery period. Not only have the central banks used creative monetary policy tools to provide stimulus, but policy makers have also more openly discussed the use of monetary policy. In spite of, or maybe because of, this improved transparency, we have experienced increased speculation and anticipation of future policy decisions, one of a number of sources of uncertainty for investors.

The third quarter was no exception to investors’ waiting and wondering as central banks signaled the willingness to use more policy tools. Through its OMT mechanism, the ECB will continue its efforts to buy sovereign debt on the secondary market, but this program is very different from past efforts. The participating countries must ask for the ECB’s backing and in return, are expected to meet strict fiscal standards. If the criteria are not met on an ongoing basis, the ECB intends to discontinue the bond purchases for that country. Unlike past programs, the ECB will give up its position as a senior creditor, sharing in potential losses with all other investors in sovereign debt. By indicating the willingness to buy unlimited amounts of bonds, the ECB intends to reassure investors that the central bank will do whatever it takes to safeguard access to affordable credit for even the weakest sovereign borrowers.

Federal Reserve Chairman Ben Bernanke cited the high unemployment rate as justification for QE3; however, with the election nearing, the additional stimulus is controversial. The Fed has two mandates – full employment and price stability. While these mandates are simple, the evidence used to judge the current condition of the economy is complex and subject to interpretation. And while the Fed is expected to operate without political bias, the central bank’s interpretation of the current environment often leads to a politically-charged debate, especially in an election year.

At times, these debates stem from the complexity of the data used to guide the Fed in policy setting. For example, over the past year the U.S. has experienced a declining unemployment rate. At face value, this seems like a positive for the U.S. economy; however, in some cases, the calculation of the unemployed includes fewer people because some have become so discouraged by the lack of job openings that they have stop searching for work altogether. In this case, a lower unemployment rate is not a signal of an improving economy. Price stability is also very complex in that the Federal Reserve excludes the volatile food and energy components, preferring to focus on core inflation. As consumers, we know that food and energy price increases are not only meaningful but sometimes painful, especially as gasoline approaches $5 per gallon.

At other times, these debates stem from the differences in the philosophical beliefs of those analyzing the data. There is general agreement that the joint efforts of central bankers around the world prevented an even deeper financial crisis in late 2008. But many, including Paul Krugman, the Nobel Prize winning economist, believe the Fed can and should do more to stimulate the economy. He contends that central banks have the tools to stimulate and ultimately to improve the economy. Without Fed intervention, millions will struggle with long-term joblessness, a price that should be unacceptable for wealthy economies such as the United States and Europe.

Others, including Mohamed El-Erian at PIMCO, the world’s largest bond investor, are concerned that the Federal Reserve is creating dependence on easy money by keeping interest rates low, forcing savers to take on risk to obtain return. His analogy is that this “sugar high” is likely to end with a crash that will ultimately leave economies around the world in worse shape. These analysts are credible and intelligent, and yet have very different beliefs about the role of central bankers and the ultimate results of policy decisions.

The ECB and the Federal Reserve are not the only central banks using monetary policy to restore their local economies to vibrancy. In an increasingly globalized world, the actions of central bankers around the world create a complex environment. When reducing interest rates, central bankers can have a meaningful impact on currency valuations. As interest rates fall, the local currency becomes less attractive for savers. This leads to a decline in value relative to other currencies that may offer higher rates of interest. As the value of a currency declines, the goods and services produced by that country become less expensive to trading partners. A robust export trade creates domestic jobs, ultimately leading to national wealth and prosperity. It is no wonder that analysts call the cuts in interest rates around the world “a race to the bottom”, referring to the push to become the cheapest currency in the exporting world.

We start the fourth quarter of this year with many unknowns ahead. Needless to say, central bank activities are only one part of our national debate prior to this election. It is often said that monetary policy is a blunt instrument, meaning the full effect of central bank decisions, both intended and unintended, will not be known for many years to come. In the face of this ongoing uncertainty, it is important to consider and review your risk tolerance regularly. Please contact your BOS team to discuss these issues, and others, pertaining to your long-term financial security.

Key Economic Indicators

Real Gross Domestic Product (real GDP) in the U.S. increased at an annual rate of 1.3% in the second quarter of 2012, a slowdown from the first quarter pace of 2.0%.

The U.S. unemployment rate decreased to 7.8% in September. This rate had stayed within a narrow range of 8.1% to 8.3% for the first 8 months of the year. The number of long-term unemployed was little changed.

Standard & Poor’s 500 Index operating earnings per share increased 2.3% in the second quarter of 2012 from the same quarter a year ago. Analysts expect a slowdown in earnings in the third quarter.

US non-farm worker productivity increased at an annual rate of 2.2% during the second quarter of 2012.

The Comex spot rate for gold increased by 10.45% in the third quarter of 2012, closing at $1,771 an ounce. Demand for gold as an alternative investment is on the rise as investors attempt to protect against the risk that monetary easing will erode the value of paper currencies. The value of gold has risen 13.11% from the beginning of the year.

Crude oil rebounded 8.5% in the third quarter, closing at $92.19 a barrel. Crude oil is down 6.72% year-to-date.

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